Implications of the Presidential Cycle

August 31, 2010

By Chris Dardaman, CPA, CFP®, CIMA®, CAIA® 

The Historical Case
Only weeks away from the major midterm elections, we have been looking at the historical evidence for insight as to how this election may impact the investment landscape. Midterm elections are sometimes regarded as a referendum on the sitting President's and/or incumbent party's performance, and they usually do not turn out well for the party in power. Over the past 17 midterm elections, the President's party lost an average of 25 seats in the House and 4 in the Senate.¹ No matter how one might interpret the political implications of midterm elections, the message for investors has been clear. The strong patterns from past elections and presidential cycles (regardless of political party) indicate that this November’s election should be a major positive for the investment markets over the next few years.     

First, the U.S. stock market has historically performed better without a “political ruling party” across the Senate, House of Representatives, and Presidency (see Chart 1).  For example, a Republican-controlled House and/or Senate with a Democrat President bodes much better for the market (based on history) than the current Democratic control of all three.  There are a number of potential reasons for this, with many believing that a split government causes the various branches and parties to work together to get legislation passed, etc. The idea is that this results in a more bi-partisan, centrist, common sense approach to government, and markets respond accordingly.  We suspect this may be the case, but perhaps more importantly, the division of power prevents major change and uncertainty as to what the government might do.  Business leaders and markets value stable rules of the game.  Perceived governmental stability is foundational for economic growth.  So for investors, gridlock is often good.

Then there is the presidential cycle. Here the data is even more compelling: since 1932, the U.S. stock market during the third year of the Presidential term has outperformed the first, second and fourth years combined.² Some think this is because Presidents don’t fully understand their job or start hitting their stride until the third year. A more cynical group thinks the third year is when sitting Presidents begin running for re-election, which makes it critically important to do whatever is necessary to stimulate the economy. Politics, fiscal and monetary stimulus and moral hazard tend to increase in ways designed to positively impact the economy. Interestingly, this phenomenon is not limited to the United States. It is even more pronounced in the U.K. and also shows up in data from other European countries and Japan.² (Perhaps this confirms the cynics’ view.)  

In any event, the third years are on average the best performing year of a President’s term, with an average return on the Dow Jones Industrial Average stocks of 15.5%. This compares to 8.8% for the first years, 0.4% for the second years and 4.1% for the fourth years.³ Based upon research by Jeremy Grantham at GMO, in the past 19 third-year Presidential terms since 1932, in 18 of the 19 time periods the U.S. stock market was up in Year.³ (The unexpected Korean War caused only a 2% decline.)² While we do not necessarily assume what happened in the past will be repeated, this historical pattern is one of the most consistent we’ve seen.  

Why it Matters for Our Future
Regardless of one’s political persuasion, very few think the current system is working well.  The approval rating of Congress is at an extremely low 19% according to Gallup.⁴ The sense that there is way too much partisanship and far too little statesmanship is not just a feeling people have; it has been documented statistically by Professors Nolan McCarty, Keith T. Poole and Howard Rosenthal. Currently, the polarization of the two political parties is extremely high; the percentage of Representatives voting with the majority of their party is at the highest level since Reconstruction in the 1870s.⁵  Regardless, since 1942 the U.S. stock market has tended to rise sharply in the first 200 days after midterm elections  (see Chart 2).  In all seventeen instances, the S&P 500 posted gains in the 200 day period following a midterm election, with the average gain of over 18% for the first 200 days.¹ This may be due to the decrease in uncertainty that takes place. Or it could be because midterm elections tend to create a more balanced division of power between the parties, which has historically been good for the stock market.   

Absent an unexpected major economic shock, given the historic amount of economic and monetary stimulus, we expect the economy will continue growing, but at a slow pace. Currently the uncertainty and concern in the business community over rising taxes, increasing regulation, and future health care costs are causing business owners to wait on implementing growth or new hiring plans. But change is on the horizon. The latest odds posted by Intrade (a political “futures” market) indicate that Republicans are very likely to take control of the House of Representatives and make gains in the Senate.⁶ If this happens, a split government should help eliminate some of the future uncertainty and create a more small business friendly environment. Business owners may be encouraged to invest and hire, leading to greater economic growth. Higher taxes will have a slowing effect on the growth of the economy, but can be overcome. Win, lose, or draw in November, just getting the election out of the way could create a “relief rally.” If the historical Presidential cycle continues and the election results are as expected, don’t be surprised to see higher future returns for the stock market.

¹ “A Mid-Term Exam,” ©The Leuthold Group 2010.  
² GMO Quarterly Letter, May 2009.
³ www.marketwatch.com
⁴ www.gallup.com
⁵ www.voteview.com
⁶ InvestmentNews, July 26, 2010.